Personal finance: Get ready now for end of payroll tax holiday

November 7th, 2012 in Business Diary

You may not even recall, but if you receive a paycheck you have been bringing home a few extra bucks every payday for the past two years thanks to a special break from Congress and the President. As of Dec. 31, this tax break will almost certainly disappear, and now is the time to prepare for lower take-home pay starting in January.

Social Security taxes on earned income are split equally between employer and employee, assessed at a rate of 6.2 percent each. As part of the response to the economic crisis and resulting recession, Congress passed and President Obama signed into law a special one-year reduction in Social Security withholding taxes for all wage earners for the tax year 2011. The measure reduced the employee portion of the withholding tax to 4.2 percent (the employer portion remained at 6.2 percent). Intended to stimulate additional consumer spending, the tax reduction put an estimated $103 billion dollars in wage earners' pockets. This measure was the latest in a series of temporary stimulus measures aimed at revving-up the 70 percent of U.S. economic output that is dependent upon consumption spending.

The measure was extended for 2012, providing another $112 billion in disposable income for workers to go out and spend.

Meanwhile, the Social Security trust fund was already disbursing more in benefits that it takes in from payroll taxes. Reducing the employee contribution rate necessitated increased government borrowing to fund the shortfall, adding another $215 to the national debt.

On the eve of expiration of the 2012 extension, it seems that nobody loves the payroll tax holiday anymore. Given that the actual beneficial impact of the reductions has been dubious and still hotly debated, no one is rushing to support an additional extension. AARP, for instance, is on record as favoring a return to the previous statutory withholding levels to mitigate further erosion in the solvency of the Social Security system. And is seems that allowing the tax break to die is one thing upon which both political parties seem to agree.

Two years hence, many workers may not recollect the temporary nature of the increase in their take-home pay. For an employee with a $40,000 annual gross income, the reversion to the old tax schedule would result in a reduction of $800 in next year's net, or about $15 per week. This is independent of any exemptions you may claim on your W-4 withholding schedule, since your entire gross pay (less contributions to a flexible benefit or MSA account) is taxed.

Now is the time to begin preparing for the inevitable cut in next year's net income. Multiply your gross pay by 2 percent and divide by the number of pay periods to estimate your additional taxes per paycheck. Then start setting aside an equivalent amount over the next few paydays to prepare for the reduction in take-home pay beginning in January, so the pay cut won't bite quite as much.

It was fun while it lasted.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.